Personal Finance Notes

Stocks & Bonds Tidbits 1. Over the long term, stocks have historically outperformed all other investments. 2. Over the short term, stocks can be hazardous to your financial health. 3. Risky investments generally pay more than safe ones (except when they fail)1. 4. The biggest single determiner of stock prices is earnings.2 5. A bad year for bonds is normal stocks. 6. Rising interest rates are bad for bonds3 7. Inflation may be the biggest threat to longterm investments. 8. U.S. Treasury bonds provide almost no risk.4 9. A diversified portfolio is less risky than a portfolio that is concentrated in one or a few investments. 10. Index mutual funds often outperform actively managed funds.5 Stocks Stocks can be divided by: • Company size (measured by market capitalization), • Sector (emerging markets, technology…) • Types of growth patterns (aggressive, income, liquid)  Stock prices track earnings. Over the short term, the behavior of the market is based on enthusiasm, fear, rumors and news. Over the long term, though, it is mainly company earnings that determine whether a stock's price will go up, down or sideways.  Stocks are your best shot for getting a return over and above the pace of inflation. The average large stock has returned more than 10 percent a year -- well ahead of inflation, and the return of bonds, real estate and other savings vehicles.  Individual stocks are not the market. A great track record does not guarantee strong performance in the future. Stock prices are based on projections of future earnings. A strong track record bodes well, 1

Investors demand a higher rate of return for taking greater risks. That's one reason that stocks, which are perceived as riskier than bonds, tend to return more. 2 Over the short term, stock prices fluctuate based on everything from interest rates to investor sentiment to the weather. But over the long term, what matters are earnings. 3 Because bond buyers won't pay as much for an existing bond with a fixed interest rate of, say, 5 percent because they know that the fixed interest on a new bond will pay more because rates in general have gone up. 4 U.S. Government is unlikely ever to default on its bonds -partly because the American economy has historically been fairly strong and partly because the government can always print more money to pay them off if need be. 5 Few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.

You can't tell how expensive a stock is by looking only at its price. Because a stock's value is depends on earnings, a $100 stock can be cheap if the company's earnings prospects are high enough, while a $2 stock can be expensive if earnings potential is dim Assessing value of a stock To get a sense of whether a stock is over- or undervalued, investors compare its price to revenue, earnings, cash flow, and other fundamental criteria. Comparing a company's performance expectations to those of its industry is also common -- firms operating in slow-growth industries are judged differently than those whose sectors are more robust. As a general rule, it's best to hold stocks from several different industries. That way, if one area of the economy goes into the dumps, you have something to fall back on. It's smarter to buy and hold good stocks than to engage in rapid-fire trading. The cost of trading has dropped; commissions are cheaper. Other costs to trading: • Mark-ups by brokers • Higher taxes for short-term trades • active trading requires paying close, up-to-theminute attention to stock-price fluctuations

Bond Tips Bonds are NOT turbo-charged CDs. Though their life span and interest payments are fixed -- thus the term "fixed-income" investments -- their returns are not. Bond prices move in the opposite direction of interest rates. When interest rates fall, bond prices rise, and vice versa. But if you hold a bond to maturity, price fluctuations don't matter. With a bond, you always get your interest and principal at maturity, assuming the issuer doesn't go belly up. With a bond fund, your return is uncertain because the fund's value fluctuates. Inflation erodes the value of bonds' fixed interest payments. Stock returns, by contrast, stand a better chance of outpacing inflation. Consider tax-free bonds. Tax-exempt municipal bonds yield less than taxable bonds, but they can still be the better choice for taxable accounts. That's because tax-free bonds sometimes net you more income than you'd get from taxable bonds after the taxes are taken out. Pay attention to total return, not just yield. A broker may sell you a bond that is paying a "coupon" -- or interest rate -- of 6 percent. If interest rates rise, however, then the price of the bond will fall. If the price drops by 2 percent, its total return for the first year -- 6 percent in income less a 2 percent capital loss -- would be only 4 percent.

If you want capital gains, go long. When interest rates are high, gamblers who want to bet that they'll head lower should buy long-term bonds or bond funds, especially "zeros." Reason: when rates fall, prices rise; and longer-term bonds gain more in price than shorter-term bonds. If you want steady income, stick with short to medium terms. Investors looking for income should invest in a laddered portfolio of short- and intermediate-term bonds.

Mutual Funds    

Performance: Long-Term Performance (past 2 years) Performance Consistency (year to year) Performance comparison (check similar funds)

 Risk:  Standard deviation, the broader the range, the higher risk  Portfolio Mix (bonds & stocks)  Portfolio Breakdown (what is the fund investing in?)  Expenses:  Loads (expenses to buy shares; commissions)  Fund Expenses (day-to-day running the fund; admin and salaries of fund employees) Index Funds An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market Economists cite the efficient market theory as the fundamental premise that justifies the creation of the index funds. Advantages: Low costs - Because the composition of a target index is a known quantity, it costs less to run an index fund.  Simplicity - Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly  Low Turnovers - refers to the selling and buying securities by the fund manager Disadvantages: Since index funds achieve market returns, there is no chance of out-performing the market. On

the other hand, it should not under-perform the market significantly. Capital Gains If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains. What is value investing? Generally buy companies whose shares appear underpriced by some forms of fundamental analysis; these may include shares that are trading at, for example, high dividend yields or low price-to-earning or price-to-book ratios. The essence of value investing is buying stocks at less than their intrinsic value "finding an outstanding company at a sensible price" rather than generic companies at a bargain price." Strategies:  Buying low PE ratio stocks  Low price-to-cash-flow ratio stocks  Low price-to-book ratio stocks Time Value of Money premise of time value of money is that an investor prefers to receive money today, rather than the same amount in the future, all else being equal. 4 variables involved in TVM  Time period  # of payments6  interest rate  Basis (value)  Present Value - How much you got now. :: what is the value now of a zero-coupon bond that will pay $1,000 in 10 years?  Future Value - How much what you got now grows to when compounded at a given rate :: how much will be in my savings account at year end, which has $1,000 in it now, and pays 5% compounded yearly?  Present Value of an Annuity (PVA) is the present value of a stream of future payments. It determines the value of your mortgage today, :: Can I afford 20 years of payments of $xxx?  Future Value of an Annuity (FVA) is the future value of a stream of payments (annuity). 6

Payments are a series of equal, evenly-spaced cash flows.

:: If I save $2,000 per year and it earns 5% compounded yearly, what will be the total sum after 40 years?

The strike price, or exercise price, is a key variable in a derivatives contract between two parties.

“concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future.”

Find the Intrinsic Value The actual value of a security, as opposed to its market price or book value.

:: INTEREST (SIMPLE VS. COMPOUND)





Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period.



Compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date



Market capitalization is the price (i.e. what investors are willing to pay for the company) Intrinsic value is the value (i.e. what the company is really worth).

Fundamental analysis - as opposed to Technical analysis - to determine the intrinsic value of a company. For equities: The "intrinsic" characteristic is the cash flow production of the company in question. Intrinsic value is therefore defined to be the present value of all future net cash flows to the company.

Interest Rates

Fundamental Analysis involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets



APR refers to the annual percentage rate of interest you are charged on your credit card. It's the same thing as your interest rate.



The Prime Rate is used by banks to set the benchmark interest rate for their loans.



Fixed Rate or fixed APR refers to an interest rate that will not change until the issuer decides to change it.

Discounted cash flow model, which calculates the present value of the future:







A variable rate is tied to a certain index (such as the prime rate, T-Bills, LIBOR, etc.), and, as the name implies, varies depending on what direction the index goes.

> Load Amortization A method for repaying a loan in equal installments. Part of each payment goes toward interest and any remainder is used to reduce the principal; As the balance of the loan is gradually reduced, a progressively larger portion of each payment goes toward reducing principal. > Negative Amortization Negative amortization occurs when the payment is not large enough to cover the interest due for a period. > What is an annuity? annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. > What is a perpetuity? Perpetuity is an annuity that has no definite end.

  

Determined growth rates (of income and cash) Determine risk levels (to determine the discount rate)

dividends received by the investor, along with the eventual sale price. (Gordon model) earnings of the company, or cash flows of the company.

Options A contract giving an investor a right to buy (call) or sell (put) a fixed amount of shares (usually 100 shares) of a given stock (or indexes and commodities) at a specified price within a limited time period (usually three, six, or nine months). The purchaser hopes that the stock's price will go up  (if he bought a call) or down (if he bought a put) by an amount sufficient to provide a profit when he sells the option.

 Calls & Puts A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a

stock. Buyers of calls hope that the stock will increase substantially before the option expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. Participants in the Options Market There are four types of participants in options markets depending on the position they take: 1. 2. 3. 4.

Buyers of calls Sellers of calls Buyers of puts Sellers of puts

 futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.  forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Arbitrage Arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices What is volatility? The traditional measure of risk is volatility, that is, the annualized standard deviation of returns. A measure of the dispersion of a set of data from its mean. The more spread apart the data is, the higher the deviation.  HEDGE FUND A hedge fund is a lightly regulated private investment fund;hedge funds do not suffer such regulatory restrictions; Mutual Funds may be limited to being "long" the market by buying instruments such as bonds, equities or money market instruments

Hedging & Speculation a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment To understand hedging is to think of it as insurance. insuring themselves against a negative event7. “Reduce their exposure to various risks” Technically, to hedge you would invest in two securities with negative correlations Hedging uses financial instruments known as derivatives8, the two most common of which are options and futures. Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements

 PRIVATE EQUITY Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Also lightly regulated

Private Equity Investment & Private Equity Funds Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, not listed on a public stock exchange; "exit" or "selling out" is often done by the way of an IPO, capitalizing the value of the security on a stock exchange. Private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. Fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount.

7

This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced

 RETIREMENT FUNDS

8

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate, or currency.



IRA Tax Deferral – Post tax; pay taxes on money you withdraw

 

Mandatory withdrawal Money grows tax free; only withdrawals are taxed

Roth IRAs Pre-taxed; No Tax deduction for deposits  Tax-Free Withdrawals  Early withdrawal penalties



Advantages  Tax free growth  Tax free withdrawal  No mandatory withdrawal (wait as long as you can want)

Underwriting Banking Underwriting: underwriting is the detailed credit analysis preceding the granting of a loan, based on credit information furnished by the borrower, such as employment history, salary, and financial statements Securities Underwriting: underwrite the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, then they end up holding some securities themselves Insurance Underwriting: insurance underwriters calculate how risky it is to insure people and businesses. They also decide how much coverage they should receive and how much they should pay for it.